Things are hotting up for bitcoin right now with the price over $420 on MtGox. CNBC's interview yesterday of the Winklevoss twins shows both the fundamental lack of understanding of bitcoin by the interviewer (asking "where is the Ben Bernanke of bitcoin?") and also the feeling many bitcoin supporters have right now: that even with the price increasing quickly (although whether the current price increase is 'quick' is debatable given the many calculations of a final prices in the order of $40k+), adoption, this time as least, seems to be increasing similarly quickly with big time players like Baidu and Shopify coming on board.

Peter Schiff though gives a scathing response to their comments: that bitcoin is a bubble (he even likens it to the Tulip bubble of 1637), that people are buying bitcoin because they think their value will increase, and that he expects it to implode.

The only reason people invest in anything is because they think their investment value will increase

Bubbles don't form simply because people buy into something that they think will increase in value. A bubble forms when the primary reason for the increase in price is an increase in demand fuelled by people thinking the price will increase (but otherwise see no significant value in it).

Peter along with many others seem to think that because people are buying bitcoins with the view that they are undervalued this constitutes a bubble, yet this is the basis of much of investing. If I buy stock in a company then it is for one of only two reasons:

A) The dividend payment

B) The stock price will go up

With (B) being a significant part if not the vast majority of investing in the world.

In terms of viewing whether a company stock is in a bubble we can look at the company's fundamentals, how much profit they make, what their long term prospects to make profit are, and we can invest based on how profitable we think the company will be not just now but in the future. This often leads us to evaluate whether companies are over or undervalued by their price to earnings (P/E) ratio.

With bitcoin, the fundamental driver of its underlying value is not selling products to make profit, it is its adoption and usage. If bitcoin's adoption is increasing (enough) then its price increase is justified. Instead if there are people piling in buying bitcoins all hoping to hold them for a short while then sell them for short term gain then the price increases while demand is there but then falls away as people being to cash out. This then accelerates are more people get concerned that they will lose their investment and cash out.

The nature of the bubble, when/whether it will pop and how far it will go if it does pop will depend on the investors, the question is: are bitcoin investors in it for the short term or the long haul?

I can't speak for everyone and there will without a doubt be those that do hope to just play the price in the short term for gains but at the same time my own perspective on and appreciation of bitcoin is nothing special so my own thinking and strategy may well match up to others that believe in the fundamental value of bitcoin, so here it is:

Step 1 - Accept that bitcoin is a great idea, but may fail

The first step is to believe that bitcoin is a genuinely beneficial and new invention. How you get to this point and what level of understanding you need is very individual but if you're going to buy bitcoin then this is likely a given.

The next step is to accept that you can't predict how life will pan out for bitcoin, and that you may be wrong. I can't predict regulation and its effects, I can't predict the development path of quantum computers, and I can't predict whether bitcoin will survive being the worlds most profitable target for hackers the world has ever seen.

What I can say is that bitcoin looks to have a lot of potential, and that I accept these risks.

Step 2 - Buy early

The next conclusion if I think bitcoin has fundamental value beyond its current price is that it is better to buy early, while the rest of the world hasn't caught on yet and while they still think bitcoin is no different to PayPal.

Because I accept the risks and because bitcoin is cheap at this point, I don't bet my house on it because I don't need to. I can buy a bunch of bitcoins and if the positive predictions of bitcoin going to $100k work out then I don't need to hold a lot of them. If the predictions don't work out and it all fails then I don't lose much.

In short, if bitcoin wins out, I win. If bitcoin loses out, I don't care - I walk away. My investment was low because I wasn't trying to secure a return of 2 or 3x, I was investing with the view that it could go to 100x.

Step 3 - Sell, but Don't panic sell

If I hold bitcoins then and their value is increasing, then you might think there is an overwhelming tendency to want to cash out and realise gains in case it crashes (or maybe when it crashes?). This assumption is wrong for a number of reasons:

I don't care if my investment loses its value. I am in it to see a 100-1000x increase, not 2 or 3x, so bitcoin increasing 2 or 3x is interesting but its not anywhere near a trigger point for me.

Even if their value increases very significantly (say 100x), because I understand and appreciate bitcoin I would still rather keep a lot of money denominated in bitcoin than USD (or some other currency) because I know currencies around the world today are inflating horribly due to Quantitative Easing and because of the risk of bail-in (confiscation). Therefore even if the price of bitcoin skyrockets and goes to $10k per bitcoin, I don't suddenly think that the best place to keep my money is in USD in a bank!

Because of the nature of the gains I expect bitcoin may make (orders of magnitude), as it hits certain points I can extract a portion of my bitcoins to realise some of the gains and diversify while still retaining the bulk of my bitcoins (and therefore the demand for bitcoin if others take the same view will remain high). For example if I bought bitcoins at $25 each, then maybe I would sell 10% at $250. This covers my initial investment 100% yet I still retain 90% of my bitcoins, thereby reinforcing (1). Similarly when it reaches some other higher number maybe I cash out another small amount to diversify yet retain the bulk. This isn't possible when the gains you expect are 10 or 20%, its only possible when you think bitcoin is undervalued by orders of magnitude.

Result? Strong hands, weak bubbles

This is just my strategy but it is based on simple logic that anyone who:

A) believes bitcoin has significant utility and that demand will ultimately drive prices much higher as a result of its adoption for that utility.

B) believes they realised this early enough that they think bitcoin will make significant gains

In this case anyone can buy a small number of bitcoins, wait, cash out partly when they can cover their investment with a fraction of the gains and then sit on the rest purely as savings.

This act of saving (which some would describe negatively as 'hoarding') is not bad for bitcoin, it is an important use of bitcoin as a safe store of value and a valid part of its demand. If people save bitcoins then it reduces the pool for other forms of adoption like use by merchants which naturally means their value must increase to meet that demand. Saying that every bitcoin must be in circulation for it to be viable is like saying USD will fail if anyone keeps them in their wallet or bank account too long.

Where it does become bad for bitcoin is if I fundamentally believe bitcoin will ultimately fail and I am holding it with a view to making some gains before cashing out.

Some will hold this view and they will undoubtedly create bubbles and pops as bitcoins adoption progresses but to call bitcoin predominantly a bubble we need to ask the questions:

Does bitcoin have fundamental utility (value)?

Are most bitcoins held by people who think it has fundamental utility (and therefore don't plan to dump them all in exchange for USD they think 'the bitcoin bubble is popping')?

Given that roughly 90% of bitcoins in circulation today were mined before the end of 2012 (when the media still laughed at them) my guess would be 'yes' to both. If I'm right then we will see bubbles and pops but rather than crashing to zero bitcoin will retain a strong base of value which will increase in line with adoption.

Thanks Luke, it's something that has been intuitively rattling around my head for some time and I felt with the recent price increases it was a good time to run through the logic in detail and clarify it.

Reply

Gp

11/14/2013 6:20am

First couple paragraphs need some major grammatical fixes but great article either way.

Reply

Max

11/14/2013 8:50am

Good article, sounds like the author knows what he's talking about, untill the last paragraph where it's said that "roughly 90% of bitcoins were mined before the end of 2012". This is wrong, at the end of 2012, 50% of the bitcoins were mint. At the end of 2016, 75% will be, 87,5% at the end of 2020, etc...

Reply

X-BTC

11/14/2013 9:09am

90% of the current total, not the final total.

Reply

X-BTC

11/14/2013 9:17am

(fixed text)

Reply

Mika

11/14/2013 10:37am

Great article! this is EXACTLY my strategy! I am doing the same for LTC and PPC.

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